**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****WASHINGTON, D.C. 20549**

# ** **

# **FORM 10-Q**

# ** **

| **ý**** Quarterly Report Pursuant to Section 13 or 15(d)** |
|----------------------------------------------------------------------|
| **of the Securities Exchange Act of 1934**                           |
|                                                                 |
| **For  the quarterly period ended March 31, 2006**                   |
| ** **                                                           |
| **or**                                                               |
|                                                                 |
| **o**** Transition Report Pursuant to Section 13 or 15(d)**     |
| **of the Securities Exchange Act of 1934**                           |

** **

**For the transition period from          to          **

 

## **Commission FileNo. 001-10924**

## ** **

| **CLAYTON WILLIAMS ENERGY, INC.**                                                            |
|----------------------------------------------------------------------------------------------|
| (Exact name of Registrant as specified in its  charter)                                      |
|                                                                                         |   |   |
| **Delaware**                                                                                 | ** ** | **75-2396863** |
| (State or other jurisdiction of                                                              |   | (I.R.S. Employer |
| incorporation or organization)                                                               |   | Identification Number) |
|                                                                                         |   |   |
| **6 Desta Drive, Suite 6500, Midland, Texas**                                                | ** ** | **79705-5510** |
| (Address of principal executive offices)                                                     |   | (Zip code) |
|                                                                                         |   |   |
| Registrant’s Telephone Number, including area code:**   (432) 682-6324** |
|                                                                                         |   |   |
| **Not applicable**                                                                           |
| (Former name, former address and former fiscal year,  if changed since last report)          |

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.   Yes   ý   No   o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 
| Large accelerated filer |   | o |   | Accelerated filer |   | ý |   | Non-accelerated filer | o |
|-------------------------|--------|---|--------|-------------------|--------|--------|--------|-----------------------|---|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).o  Yes      ý  No

 

Therewere 10,849,461 shares of Common Stock, $.10 par value, of the registrantoutstanding as of May 5, 2006.

 

 

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**CLAYTON WILLIAMS ENERGY, INC.**

**TABLE OF CONTENTS**

 
| **PART I.  FINANCIAL INFORMATION** |                                                                                            |
|------------------------------------|-------------------------------------------------------------------------------------------------|
|                               |                                                                                            |   |
| Item 1.                            | Financial Statements                                                                            |   |
|                               |                                                                                            |   |
|                               | Consolidated  Balance Sheets as of March 31, 2006  and December 31, 2005                   |   |
|                               |                                                                                            |   |
|                               | Consolidated  Statements of Operations for the three months  ended March 31, 2006 and 2005      |   |
|                               |                                                                                            |   |
|                               | Consolidated  Statement of Stockholders’ Equity for the three months  ended March 31, 2006 |   |
|                               |                                                                                            |   |
|                               | Consolidated  Statements of Cash Flows for the three months  ended March 31, 2006 and 2005      |   |
|                               |                                                                                            |   |
|                               | Notes  to Consolidated Financial Statements                                                     |   |
|                               |                                                                                            |   |
| Item 2.                            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations     |   |
|                               |                                                                                            |   |
| Item 3.                            | Quantitative  and Qualitative Disclosure About Market Risks                                     |   |
|                               |                                                                                            |   |
| Item 4.                            | Controls and  Procedures                                                                        |   |
|                               |                                                                                            |   |
| **PART II. OTHER  INFORMATION**    | ** **                                                                                      |
| ** **                         | ** **                                                                                      | ** ** |
| Item 1A.                           | Risk  Factors                                                                                   |   |
|                               |                                                                                            |   |
| Item 6.                            | Exhibits                                                                                        |   |
|                               |                                                                                            |   |
|                               | Signatures                                                                                      |   |

 

2

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**CLAYTON WILLIAMS ENERGY, INC.**

### **CONSOLIDATED BALANCE SHEETS**

**(Dollars in thousands)**

 

**ASSETS**

 
| ** **                                                 | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                 | ** ** | **(Unaudited)**          | ** ** | ** **                  | ** ** |
| CURRENT ASSETS                                             |       |                     |       |                        |       |
| Cash and cash  equivalents                                 |       | $                        | 8,660      |                        | $          | 5,935 |   |
| Accounts  receivable:                                      |       |                     |       |                        |       |
| Oil and gas  sales, net                                    |       | 22,619                   |       | 28,317                      |       |
| Joint interest  and other, net                             |       | 8,120                    |       | 6,972                       |       |
| Affiliates                                                 |       | 758                      |       | 254                         |       |
| Inventory                                                  |       | 45,088                   |       | 43,753                      |       |
| Deferred income  taxes                                     |       | 427                      |       | 439                         |       |
| Fair value of  derivatives                                 |       | 339                      |       | 191                         |       |
| Prepaids and  other                                        |       | 1,481                    |       | 2,581                       |       |
|                                                       |       | 87,492                   |       | 88,442                      |       |
| PROPERTY AND  EQUIPMENT                                    |       |                     |       |                        |       |
| Oil and gas  properties, successful efforts method         |       | 1,090,976                |       | 1,037,862                   |       |
| Natural gas  gathering and processing systems              |       | 18,043                   |       | 18,034                      |       |
| Other                                                      |       | 14,626                   |       | 12,396                      |       |
|                                                       |       | 1,123,645                |       | 1,068,292                   |       |
| Less accumulated  depreciation, depletion and amortization |       | (608,854                 | )          | (594,225                    | )          |
| Property and  equipment, net                               |       | 514,791                  |       | 474,067                     |       |
|                                                       |       |                     |       |                        |       |
| OTHER ASSETS                                               |       |                     |       |                        |       |
| Debt issue costs                                           |       | 8,187                    |       | 8,557                       |       |
| Advances to  drilling rig joint venture                    |       | 16,776                   |       | 10,329                      |       |
| Fair value of  derivatives                                 |       | 101                      |       | 127                         |       |
| Other                                                      |       | 5,315                    |       | 5,813                       |       |
|                                                       |       | 30,379                   |       | 24,826                      |       |
|                                                       |       | $                        | 632,662    |                        | $          | 587,335 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

3

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** **

**LIABILITIES AND STOCKHOLDERS’EQUITY**

 
| ** **                                                                                                                                                           | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                           | ** ** | **(Unaudited)**          | ** ** | ** **                  | ** ** |
| CURRENT  LIABILITIES                                                                                                                                                 |       |                     |       |                        |       |
| Accounts  payable:                                                                                                                                                   |       |                     |       |                        |       |
| Trade                                                                                                                                                                |       | $                        | 60,096     |                        | $          | 59,861 |   |
| Oil and gas  sales                                                                                                                                                   |       | 12,877                   |       | 18,236                      |       |
| Affiliates                                                                                                                                                           |       | 1,829                    |       | 2,857                       |       |
| Current  maturities of long-term debt                                                                                                                                |       | 12                       |       | 19                          |       |
| Fair value of  derivatives                                                                                                                                           |       | 31,857                   |       | 33,670                      |       |
| Accrued  liabilities and other                                                                                                                                       |       | 5,426                    |       | 9,611                       |       |
|                                                                                                                                                                 |       | 112,097                  |       | 124,254                     |       |
| NON-CURRENT  LIABILITIES                                                                                                                                             |       |                     |       |                        |       |
| Long-term debt                                                                                                                                                       |       | 291,700                  |       | 235,700                     |       |
| Deferred income  taxes                                                                                                                                               |       | 38,847                   |       | 37,042                      |       |
| Fair value of  derivatives                                                                                                                                           |       | 45,135                   |       | 49,705                      |       |
| Other                                                                                                                                                                |       | 20,935                   |       | 20,343                      |       |
|                                                                                                                                                                 |       | 396,617                  |       | 342,790                     |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                       |       |                     |       |                        |       |
|                                                                                                                                                                 |       |                     |       |                        |       |
| STOCKHOLDERS’  EQUITY                                                                                                                                           |       |                     |       |                        |       |
| Preferred stock,  par value $.10 per share, authorized – 3,000,000 shares; issued – none                                                                   |       | —                   |       | —                      |       |
| Common stock,  par value $.10 per share, authorized – 30,000,000 shares; issued and  outstanding – 10,848,450 shares in 2006 and 10,815,575 shares in 2005 |       | 1,085                    |       | 1,082                       |       |
| Additional  paid-in capital                                                                                                                                          |       | 107,386                  |       | 107,108                     |       |
| Retained  earnings                                                                                                                                                   |       | 15,477                   |       | 12,101                      |       |
|                                                                                                                                                                 |       | 123,948                  |       | 120,291                     |       |
|                                                                                                                                                                 |       | $                        | 632,662    |                        | $          | 587,335 |   |

** **

The accompanying notesare an integral part of these consolidated financial statements.

 

4

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**CLAYTON WILLIAMS ENERGY, INC.**

**CONSOLIDATED STATEMENTS OFOPERATIONS**

**(Unaudited)**

**(In thousands, except per share)**

** **
| ** **                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| REVENUES                                     |       |                                             |       |   |   |
| Oil and gas  sales                           |       | $                                                | 60,181     |   | $ | 61,496 |   |
| Natural gas  services                        |       | 3,196                                            |       | 2,581 |   |
| Gain on sales of  property and equipment     |       | 17                                               |       | 1,612 |   |
| Total revenues                               |       | 63,394                                           |       | 65,689 |   |
|                                         |       |                                             |       |   |   |
| COSTS AND  EXPENSES                          |       |                                             |       |   |   |
| Production                                   |       | 14,965                                           |       | 12,571 |   |
| Exploration:                                 |       |                                             |       |   |   |
| Abandonments and  impairments                |       | 12,843                                           |       | 11,270 |   |
| Seismic and  other                           |       | 3,101                                            |       | 788 |   |
| Natural gas  services                        |       | 2,829                                            |       | 2,417 |   |
| Depreciation,  depletion and amortization    |       | 14,710                                           |       | 12,292 |   |
| Accretion of  abandonment obligations        |       | 379                                              |       | 279 |   |
| General and  administrative                  |       | 4,067                                            |       | 2,518 |   |
| Loss on sales of  property and equipment     |       | 13                                               |       | 32 |   |
| Total costs and  expenses                    |       | 52,907                                           |       | 42,167 |   |
| Operating income                             |       | 10,487                                           |       | 23,522 |   |
| OTHER INCOME  (EXPENSE)                      |       |                                             |       |   |   |
| Interest expense                             |       | (4,339                                           | )          | (2,366 | ) |
| Loss on  derivatives                         |       | (1,572                                           | )          | (35,089 | ) |
| Other                                        |       | 618                                              |       | 446 |   |
| Total other  income (expense)                |       | (5,293                                           | )          | (37,009 | ) |
| Income (loss)  before income taxes           |       | 5,194                                            |       | (13,487 | ) |
| Income tax  expense (benefit)                |       | 1,818                                            |       | (4,495 | ) |
| NET INCOME  (LOSS)                           |       | $                                                | 3,376      |   | $ | (8,992 | ) |
| Net income  (loss) per common share:         |       |                                             |       |   |   |
| Basic                                        |       | $                                                | 0.31       |   | $ | (0.83 | ) |
| Diluted                                      |       | $                                                | 0.30       |   | $ | (0.83 | ) |
|                                         |       |                                             |       |   |   |
| Weighted average  common shares outstanding: |       |                                             |       |   |   |
| Basic                                        |       | 10,841                                           |       | 10,792 |   |
| Diluted                                      |       | 11,351                                           |       | 10,792 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

5

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**CLAYTON WILLIAMS ENERGY, INC.**

**CONSOLIDATED STATEMENT OFSTOCKHOLDERS’ EQUITY**

**(Unaudited)**

**(In thousands)**

 
| ** **                                    | ** ** | **Common Stock**   | ** ** | **Additional**

**Paid-In  Capital** | ** ** | ** ** | ** **             |
|-----------------------------------------------|------------|-------------------------|------------|--------------------------------------|------------|------------|------------------------|
| ** **                                    | ** ** | **No. of  Shares** | ** ** | **Par  Value**                       | ** ** | ** ** | **Retained  Earnings** | ** ** |
| BALANCE,                                      |       |                    |       |                                 |       |       |                   |   |   |
| December 31,  2005                            |       | 10,815                  |       | $                                    | 1,082      |       | $                      | 107,108 |   | $ | 12,101 |   |
| Net income and  total comprehensive income    |       | —                  |       | —                               |       | —     |                   | 3,376 |   |
| Issuance of  stock through compensation plans |       | 33                      |       | 3                                    |       | 278        |                   | — |   |
| BALANCE,                                      |       |                    |       |                                 |       |       |                   |   |   |
| March 31, 2006                                |       | 10,848                  |       | $                                    | 1,085      |       | $                      | 107,386 |   | $ | 15,477 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

6

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**CLAYTON WILLIAMS ENERGY, INC.**

**CONSOLIDATED STATEMENT OF CASHFLOWS**

**(Unaudited)**

**(In thousands)**

 
| ** **                                                                            | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES                                                 |       |                                             |       |   |   |
| Net income  (loss)                                                                    |       | $                                                | 3,376      |   | $ | (8,992 | ) |
| Adjustments to  reconcile net income (loss) to cash provided by operating activities: |       |                                             |       |   |   |
| Depreciation,  depletion and amortization                                             |       | 14,710                                           |       | 12,292 |   |
| Exploration  costs                                                                    |       | 12,843                                           |       | 11,270 |   |
| (Gain) loss on  sales of property and equipment, net                                  |       | (4                                               | )          | (1,580 | ) |
| Deferred income  taxes                                                                |       | 1,818                                            |       | (4,651 | ) |
| Non-cash  employee stock compensation                                                 |       | 605                                              |       | 333 |   |
| Unrealized  (gain) loss on derivatives                                                |       | (6,505                                           | )          | 31,452 |   |
| Settlements on  derivatives with financing elements                                   |       | 7,921                                            |       | 4,205 |   |
| Amortization of  debt issue costs                                                     |       | 371                                              |       | — |   |
| Accretion of  abandonment obligations                                                 |       | 379                                              |       | 279 |   |
|                                                                                  |       |                                             |       |   |   |
| Changes in  operating working capital:                                                |       |                                             |       |   |   |
| Accounts  receivable                                                                  |       | 4,046                                            |       | (4,467 | ) |
| Accounts payable                                                                      |       | 867                                              |       | (10,166 | ) |
| Other                                                                                 |       | (2,891                                           | )          | (29 | ) |
| Net cash  provided by operating activities                                            |       | 37,536                                           |       | 29,946 |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES                                                 |       |                                             |       |   |   |
| Additions to  property and equipment                                                  |       | (75,616                                          | )          | (38,814 | ) |
| Proceeds from  sales of property and equipment                                        |       | 29                                               |       | 1,694 |   |
| Other                                                                                 |       | (7,471                                           | )          | (278 | ) |
| Net cash used in  investing activities                                                |       | (83,058                                          | )          | (37,398 | ) |
| CASH FLOWS FROM  FINANCING ACTIVITIES                                                 |       |                                             |       |   |   |
| Proceeds from  long-term debt                                                         |       | 56,000                                           |       | 6,200 |   |
| Repayments of  long-term debt                                                         |       | (7                                               | )          | — |   |
| Proceeds from  sale of common stock                                                   |       | 175                                              |       | — |   |
| Settlements on  derivatives with financing elements                                   |       | (7,921                                           | )          | (4,205 | ) |
| Net cash  provided by financing activities                                            |       | 48,247                                           |       | 1,995 |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                                 |       | 2,725                                            |       | (5,457 | ) |
| CASH AND CASH  EQUIVALENTS                                                            |       |                                             |       |   |   |
| Beginning of  period                                                                  |       | 5,935                                            |       | 16,359 |   |
| End of period                                                                         |       | $                                                | 8,660      |   | $ | 10,902 |   |
| SUPPLEMENTAL  DISCLOSURES                                                             |       |                                             |       |   |   |
| Cash paid for  interest, net of amounts capitalized                                   |       | $                                                | 8,212      |   | $ | 2,602 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

7

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**CLAYTONWILLIAMS ENERGY, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**March 31, 2006**

**(Unaudited)**

 

**1.****             Natureof Operations**

 

ClaytonWilliams Energy, Inc. (a Delaware corporation) and its subsidiaries(collectively, the “Company” or “CWEI”) is an independent oil and gas companyengaged in the exploration for and development and production of oil andnatural gas primarily in its core areas in Texas, Louisiana and New Mexico. Approximately45% of the Company’s outstanding common stock is beneficially owned by itsChairman of the Board and Chief Executive Officer, Clayton W. Williams (“Mr. Williams”).Oil and gas exploration and production is the only business segment in whichthe Company operates.

 

Substantiallyall of the Company’s oil and gas production is sold under short-term contractswhich are market-sensitive. Accordingly, the Company’s financial condition,results of operations, and capital resources are highly dependent uponprevailing market prices of, and demand for, oil and natural gas. Thesecommodity prices are subject to wide fluctuations and market uncertainties dueto a variety of factors that are beyond the control of the Company. Thesefactors include the level of global demand for petroleum products, foreignsupply of oil and gas, the establishment of and compliance with productionquotas by oil-exporting countries, weather conditions, the price andavailability of alternative fuels, and overall economic conditions, bothforeign and domestic.

 

**2.****             Presentation**

 

Thepreparation of these consolidated financial statements in conformity withaccounting principles generally accepted in the United States requiresmanagement of the Company to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting periods. Actual resultscould differ materially from those estimates.

 

In theopinion of management, the Company’s unaudited consolidated financialstatements as of March 31, 2006 and for the interim periods ended March 31,2006 and 2005 include all adjustments which are necessary for a fairpresentation in accordance with accounting principles generally accepted in theUnited States. These interim results are not necessarily indicative of theresults to be expected for the year ending December 31, 2006.

 

Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States have been condensed or omitted in this Form 10-Q pursuant to therules and regulations of the Securities and Exchange Commission (“SEC”). Theseconsolidated financial statements should be read in conjunction with theaudited consolidated financial statements and notes thereto included in theCompany’s 2005 Form 10-K.

 

**3.****             RecentAccounting Pronouncements**

 

EmergingIssues Task Force Issue 04-5 (“EITF 04-5”), which became effective January 1,2006, requires companies to fully consolidate any limited partnerships that thecompany controls as general partner. EITF 04-5 presumes that a sole generalpartner in a limited partnership controls the limited partnership; however, thepresumption of control can be overcome if the limited partners have (i) thesubstantive ability to remove the sole general partner or otherwise dissolvethe limited partnership or (ii)

 

8

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substantive participating rights. For this purpose, the EITF hasconcluded that a general partner lacks control if the limited partners canremove the general partner with a simple majority vote. The Company has enteredinto contracts with 17 oil and gas limited partnerships of which the Company isthe sole general partner. Generally, these contracts require the Company toabstain from voting any of its limited partnership units in matters related tothe removal of the Company as general partner. As a result, the limited partnersin all of the oil and gas partnerships in which the Company serves as generalpartner can remove the Company as general partner with a simple majority vote. Accordingly,the Company will continue consolidating its proportionate share of all of theselimited partnerships. The adoption of EITF 04-5 had no affect on the Company’sconsolidated financial statements.

 

**4.****             Long-TermDebt**

 

Long-termdebt consists of the following:

 
| ** **                                  | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                  | ** ** | **(In thousands)**  | ** ** |
| 73⁄4% Senior Notes  due 2013             |       | $                        | 225,000    |                        | $          | 225,000 |   |
| Secured bank  credit facility, due May 2007 |       | 66,700                   |       | 10,700                      |       |
| Other                                       |       | 12                       |       | 19                          |       |
|                                        |       | 291,712                  |       | 235,719                     |       |
| Less current  maturities                    |       | (12                      | )          | (19                         | )          |
|                                        |       | $                        | 291,700    |                        | $          | 235,700 |   |

 

*73⁄4% Senior Notes due 2013*

In July 2005, the Company issued, in a private placement,$225 million of aggregate principal amount of 73⁄4% Senior Notes due 2013 (“SeniorNotes”). The Senior Notes were issued at face value and bear interest at 73⁄4%per year, payable semi-annually on February 1 and August 1 of each year, beginningFebruary 1, 2006. After the payment of typical transaction expenses, netproceeds of approximately $217 million were used to repay all amountsoutstanding under the secured bank credit facilities and for general corporatepurposes, including the funding of planned exploration and developmentactivities.

 

At any time prior to August 1, 2008, the Company may redeem up to 35% ofthe aggregate principal amount of the Senior Notes with the proceeds of certainequity offerings at a redemption price of 107.75% of the principal amount, plusaccrued and unpaid interest. In addition, prior to August 1, 2009, the Companymay redeem some or all of the Senior Notes at a redemption price equal to 100%of the principal amount of the Senior Notes to be redeemed, plus a make-wholepremium, plus any accrued and unpaid interest. On and after August 1, 2009, theCompany may redeem some or all of the Senior Notes at redemption prices(expressed as percentages of principal amount) equal to 103.875% for thetwelve-month period beginning on August 1, 2009, 101.938% for thetwelve-month period beginning on August 1, 2010, and 100.00% beginning onAugust 1, 2011, for any period thereafter, in each case plus accrued and unpaidinterest.

 

The Indenture governing the Senior Notes restricts the ability of theCompany and its restricted subsidiaries to: (i) borrow money; (ii) issue redeemable and preferred stock;(iii) pay distributions or dividends; (iv) make investments; (v) createliens without securing the Senior Notes; (vi) enter into agreements thatrestrict dividends from subsidiaries; (vii) sell certain assets or mergewith or into other companies; (viii) enter into transactions withaffiliates; (ix) guarantee indebtedness; and (x) enter into new linesof business. The Company was in compliance with these covenants atMarch 31, 2006.

 

9

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*SecuredBank Credit Facility*

The Company’s secured bank credit facility provides for a revolving loanfacility in an amount not to exceed the lesser of the borrowing base, asestablished by the banks, or that portion of the borrowing base determined bythe Company to be the elected borrowing limit.  The borrowing base, whichis based on the discounted present value of future net revenues from oil andgas production, is subject to redetermination at any time, but at leastsemi-annually in May and November, and is made at the discretion of thebanks.  If, at any time, the redetermined borrowing base is less than theamount of outstanding indebtedness, the Company will be required to (i) pledgeadditional collateral, (ii) prepay the excess in not more than five equalmonthly installments, or (iii) elect to convert the entire amount ofoutstanding indebtedness to a term obligation based on amortization formulasset forth in the loan agreement.  Substantially all of the Company’s oiland gas properties are pledged to secure advances under the credit facility. AtMarch 31, 2006, the borrowing base established by the banks was$150 million, with no monthly commitment reductions.  After allowingfor outstanding letters of credit totaling $804,000, the Company had $82.5 millionavailable under the credit facility at March 31, 2006.

 

The revolving credit facility provides for interest at rates based on theagent bank’s prime rate plus margins ranging from .25% to 1%, or if elected bythe Company based on LIBOR plus margins ranging from 1.5% to 2.25%. The Companyalso pays a commitment fee on the unused portion of the revolving creditfacility. The prime rate margin is currently 2.5%, and the LIBOR margin is 4%.Interest and fees are payable at least quarterly. The effective annual interestrate on borrowings under the combined credit facility, excluding bank fees andamortization of debt issue costs, for the three months ended March 31, 2006was 7.7%.

 

The loan agreement applicable to the revolving credit facility containsfinancial covenants that are computed quarterly. The working capital covenantrequires the Company to maintain a ratio of current assets to currentliabilities of at least 1 to 1. Another financial covenant under the creditfacility requires the Company to maintain a ratio of indebtedness to cash flowof no more than 3 to 1. The computations of current assets, currentliabilities, cash flow and indebtedness are defined in the loan agreement. TheCompany was in compliance with all financial and non-financial covenants at March 31,2006.

 

**5.****            ****OtherNon-Current Liabilities**

 

Other non-current liabilities consist of the following:

 
| ** **               | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **               | ** ** | **(In thousands)**  | ** ** |
| Abandonment  obligations |       | $                        | 20,055     |                        | $          | 19,447 |   |
| Other                    |       | 880                      |       | 896                         |       |
|                     |       | $                        | 20,935     |                        | $          | 20,343 |   |

 

10

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Changes in abandonmentobligations for the three months ended March 31, 2006 and 2005 are asfollows:

 
| ** **                                         | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| ** **                                         | ** ** | **(In thousands)**                          | ** ** |
| Beginning of  period                               |       | $                                                | 19,447     |   | $ | 16,147 |   |
| Additional  abandonment obligations from new wells |       | 328                                              |       | 140 |   |
| Sales or  abandonments of properties               |       | (82                                              | )          | (42 | ) |
| Revisions of  previous estimates                   |       | (17                                              | )          | — |   |
| Accretion  expense                                 |       | 379                                              |       | 279 |   |
| End of period                                      |       | $                                                | 20,055     |   | $ | 16,524 |   |

 

**6.****             CompensationPlans**

 

*Stock-Based Compensation*

In January 2006, theCompany adopted Statement of Financial Accounting Standards No. 123 (revised2004) “Share-Based Payments” (“SFAS 123R”). SFAS 123R requires thatthe cost from all share-based payment transactions, including stock options, berecognized in the financial statements at fair value. Under SFAS 123R,compensation expense related to the grant of stock options will be determinedbased on the grant date fair value of future awards. Prior to adoption ofSFAS 123R, the Company accounted for stock-based compensation utilizingthe intrinsic value method prescribed by Accounting Principles Board OpinionNo. 25 “Accounting for Stock Issued to Employee” (“APB 25”) andrelated interpretations.

 

The Company hasaccounted for options which were repriced in 1999 as variable stock options underAPB 25 whereby compensation expense has been recognized throughDecember 31, 2005 for unexercised options based on changes in the marketvalue of the Company’s common stock. In accordance with SFAS 123R, theCompany ceased accounting for these options as variable stock options upon theadoption date. The Company adopted SFAS 123R using the modifiedprospective application method. Since all of the Company’s outstanding options werefully vested at January 31, 2006, no future compensation expense will berecognized under SFAS 123R unless the options are modified, and theCompany did not recognize any cumulative effect of change in accountingprinciples upon adoption of SFAS 123R.

 

For the three monthsended March 31, 2006, the Company did not recognize any compensationexpense related to stock-based compensation plans. For the three months endedMarch 31, 2005, the Company recognized $118,000 of compensation expenseand a related tax benefit of $41,000 related to stock-based compensation plans.

 

The Company has reserved1,798,200 shares of common stock for issuance under the 1993 Stock CompensationPlan (“1993 Plan”). The Plan provides for the issuance of nonqualified stockoptions with an exercise price which is not less than the market value of theCompany’s common stock on the date of grant. All options granted throughMarch 31, 2006 expire 10 years from the date of grant and becomeexercisable based on varying vesting schedules.

 

11

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The Company has reserved86,300 shares of common stock for issuance under the Outside Directors StockOption Plan (“Directors Plan”). Since the inception of the Directors Plan, theCompany has issued options covering 44,000 shares of common stock at optionprices ranging from $3.25 to $41.74 per share. All outstanding options expire10 years from the grant date and are fully exercisable upon issuance.

 

The following table setsforth certain information regarding the Company’s stock option plans as of and forthe three months ended March 31, 2006:

 
| ** **                      | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|---------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at  January 1, 2006 |       | 1,338,551  |       | $                                      | 19.53      |                                                |       |                            |       |   |
| Granted                         |       | 4,000      |       | $                                      | 41.74      |                                                |       |                            |       |   |
| Exercised                       |       | (30,566    | )          | $                                      | 5.72       |                                                |       |                            |       | $ | 1,374,305 |   |
| Outstanding at  March 31, 2006  |       | 1,311,985  |       | $                                      | 19.91      |                                                | 3.9        |                            | $          | 27,558,439 |   |
| Vested at March  31, 2006       |       | 1,311,985  |       | $                                      | 19.91      |                                                | 3.9        |                            | $          | 27,558,439 |   |
| Exercisable at  March 31, 2006  |       | 1,311,985  |       | $                                      | 19.91      |                                                | 3.9        |                            | $          | 27,558,439 |   |
|                                 |            |            |            |                                        |            |                                                     |            |                                 |            |  |  |  |  |

 

The following pro formainformation, as required by Statement of Financial Accounting StandardsNo. 123 “Accounting for Stock-Based Compensation” (“SFAS 123”), asamended by Statement of Financial Accounting Standards No. 148 (“SFAS 148”),presents net income and earnings per share information as if the stock optionsissued since December 31, 1994 were accounted for using the fair valuemethod under SFAS 123. The fair value of stock operations issued for eachyear was estimated at the date of grant using the Black-Scholes option pricingmodel.

 

The SFAS 123 proforma information for the three months ended March 31, 2005 is as follows:

 
| ** **                                                                                  | ** ** | **Three Months  Ended  March 31, 2005** | ** ** |
|---------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **(In thousands,  except per share)**   | ** ** |
| Net income  (loss), as reported                                                             |       | $                                                      | (8,992     | ) |
| Add: Stock-based  employee compensation expense (credit) included in net income, net of tax |       | 77                                                     |       |
| Net income  (loss), pro forma                                                               |       | $                                                      | (8,915     | ) |
| Basic:                                                                                      |       |                                                   |       |
| Net income  (loss) per common share, as reported                                            |       | $                                                      | (.83       | ) |
| Net income  (loss) per common share, pro forma                                              |       | $                                                      | (.83       | ) |
| Diluted:                                                                                    |       |                                                   |       |
| Net income  (loss) per common share, as reported                                            |       | $                                                      | (.83       | ) |
| Net income  (loss) per common share, pro forma                                              |       | $                                                      | (.83       | ) |

 

12

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*After-Payout Working Interest Incentive Plans*

InSeptember 2002, the Compensation Committee of the Board of Directors adopted anincentive plan for officers, key employees and consultants, excludingMr. Williams, who promote the Company’s drilling and acquisition programs.Management’s objective in adopting this plan is to further align the interestsof the participants with those of the Company by granting the participants anafter-payout working interest in the production developed, directly orindirectly, by the participants. The plan provides for the creation of a seriesof limited partnerships to which the Company, as general partner, contributes aportion of its working interest in wells drilled within certain areas, and thekey employee and consultants, as limited partners, contribute cash. The Companypays all costs and receives all revenues until payout of its costs, plusinterest. At payout, the limited partners receive 99% of all subsequentrevenues and pay 99% of all subsequent expenses attributable to thepartnerships’ interests.

 

Between3% and 6% of the Company’s working interests in certain specified wells drilledby the Company subsequent to October 2002 are subject to this arrangement. TheCompany consolidates its proportionate share of the assets, liabilities,revenues, expenses and oil and gas reserves of these partnerships in itsconsolidated financial statements. In April 2004, one of the partnershipsachieved payout, and the Company’s interest in the partnership was reduced to1%. Aggregate cash distributions of approximately $61,000 were paid to thelimited partners during 2006. During the three months ended March 31, 2006,the Company recognized $500,000 of non-cash compensation expense for theestimated value of the after-payout interests subject to this arrangement.

 

**7.****             Derivatives**

 

# ***Commodity Derivatives***

From time to time, theCompany utilizes commodity derivatives, consisting of swaps, floors andcollars, to attempt to optimize the price received for its oil and gasproduction. When using swaps to hedge oil and natural gas production, theCompany receives a fixed price for the respective commodity and pays a floatingmarket price as defined in each contract (generally NYMEX futures prices),resulting in a net amount due to or from the counterparty. In floortransactions, the Company receives a fixed price (put strike price) if themarket price falls below the put strike price for the respective commodity. Ifthe market price is greater than the put strike price, no payments are due fromeither party. Costless collars are a combination of puts and calls, and containa fixed floor price (put strike price) and ceiling price (call strike price). Ifthe market price for the respective commodity exceeds the call strike price orfalls below the put strike price, then the Company receives the fixed price andpays the market price. If the market price is between the call and the put strikeprices, no payments are due from either party.

 

13

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                The following summarizes informationconcerning the Company’s net positions in open commodity derivatives applicableto periods subsequent to March 31, 2006. The settlement prices ofcommodity derivatives are based on NYMEX futures prices.

 

**Collars:**

** **
| ** **          | ** ** | **Gas**          | ** ** | **Oil**   | ** ** |
|---------------------|------------|------------------|------------|-----------|------------|
| ** **          | ** ** | **MMBtu****(a)** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** | **Bbls** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** |
| Production  Period: |       |             |       |      |       |   |   |   |   |   |   |   |   |
| 2nd  Quarter 2006   |       | 551,000          |       | $         | 4.00       |   | $ | 5.21 |   | 156,000 |   | $ | 23.00 |   | $ | 25.32 |   |
| 3rd  Quarter 2006   |       | 456,000          |       | $         | 4.00       |   | $ | 5.21 |   | 150,000 |   | $ | 23.00 |   | $ | 25.32 |   |
| 4th  Quarter 2006   |       | 456,000          |       | $         | 4.00       |   | $ | 5.21 |   | 150,000 |   | $ | 23.00 |   | $ | 25.32 |   |
| 2007                |       | 1,831,000        |       | $         | 4.00       |   | $ | 5.18 |   | 562,000 |   | $ | 23.00 |   | $ | 25.20 |   |
| 2008                |       | 1,279,000        |       | $         | 4.00       |   | $ | 5.15 |   | 392,000 |   | $ | 23.00 |   | $ | 25.07 |   |
|                |       | 4,573,000        |       |      |       |   |   | 1,410,000 |   |   |   |   |   |

 

----

(a)               One MMBtu equals one Mcf at a Btu factor of1,000.

 

Subsequent to March 31, 2006, the Companyentered into swap agreements covering 1,050,000 MMBtu of gas production duringthe fourth quarter of 2006 at $10.03 per MMBtu and 5,350,000 MMBtu of gasproduction during 2007 at $10.23 per MMBtu.

 

The Company is a party to interest rate swaps thatwere acquired in connection with the acquisition of Southwest Royalties, Inc.in May 2004. Under these derivatives, the Company pays a fixed rate for thenotional principal balances and receives a floating market rate based on LIBOR.The following summarizes information concerning the Company’s net positions inopen interest rate swaps applicable to periods subsequent to March 31,2006.

 

**Interest Rate Swaps:**

** **
| ** **                            | ** ** | **Principal  Balance** | ** ** | **Libor  Rates** | ** ** |
|---------------------------------------|------------|------------------------|------------|------------------|------------|
| Period:                               |       |                   |       |             |       |
| April 1, 2006 to  November 1, 2006    |       | $                      | 55,000,000 |             | 4.29       | % |
| November 1, 2006  to November 1, 2007 |       | $                      | 50,000,000 |             | 5.19       | % |
| November 1, 2007  to November 1, 2008 |       | $                      | 45,000,000 |             | 5.73       | % |

 

*AccountingFor Derivatives*

TheCompany accounts for its derivatives in accordance with Statement of FinancialAccounting Standards No. 133 “Accounting for Derivative Instruments andHedging Activities” (“SFAS 133”), as amended. The Company did notdesignate any of its currently open commodity or interest rate derivatives ascash flow hedges; therefore, all changes in the fair value of these contractsprior to maturity, plus any realized gains or losses at maturity, are recordedas other income (expense) in the Company’s statements of operations. For theperiod ended March 31, 2006, the Company reported a $1.6 million netloss on derivatives, consisting of a $6.5 million gain related to changes inmark-to-market valuations and an $8.1 million cash charge for settledcontracts. For the period ended March 31, 2005, loss on derivates was$35.1 million, consisting of a $31.5 million non-cash charge related tochanges in mark-to-market valuations and a $3.6 million cash charge for settledcontracts.

 

14

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**8.****             FinancialInstruments**

 

Cashand cash equivalents, receivables, accounts payable and accrued liabilitieswere each estimated to have a fair value approximating the carrying amount dueto the short maturity of those instruments. Indebtedness under the secured bankcredit facilities was estimated to have a fair value approximating the carryingamount since the stated interest rate is generally market sensitive. Abandonmentobligations are carried at net present value which approximates their fairvalue since the discount rate is based on the Company’s credit-adjusted,risk-free rate. The fair value of other noncurrent liabilities approximatetheir carrying value.

 

Thefair values of derivatives as of March 31, 2006 and December 31, 2005 areset forth below. The associated carrying values at these dates are equal totheir estimated fair values.

 
| ** **                 | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                 | ** ** | **(In thousands)**  | ** ** |
| Assets  (liabilities):     |       |                     |       |                        |       |
| Commodity  derivatives     |       | $                        | (76,643    | )                           | $          | (82,635 | ) |
| Interest rate  derivatives |       | 91                       |       | (422                        | )          |
| Net assets  (liabilities)  |       | $                        | (76,552    | )                           | $          | (83,057 | ) |

 

**9.****             IncomeTaxes**

 

Deferredtax assets and liabilities are the result of temporary differences between thefinancial statement carrying values and the tax bases of assets and liabilities.Significant components of net deferred tax liabilities at March 31, 2006and December 31, 2005 are as follows:

 
| ** **                                            | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                            | ** ** | **(In thousands)**  | ** ** |
| Deferred tax  assets:                                 |       |                     |       |                        |       |
| Net operating  loss carryforwards                     |       | $                        | 5,807      |                        | $          | 2,497 |   |
| Fair value of  derivatives                            |       | 26,629                   |       | 28,906                      |       |
| Credits related  to alternative minimum tax           |       | 395                      |       | 395                         |       |
| Statutory  depletion carryforwards                    |       | 4,018                    |       | 3,861                       |       |
| Other                                                 |       | 6,108                    |       | 5,748                       |       |
|                                                  |       | 42,957                   |       | 41,407                      |       |
| Deferred tax  liabilities:                            |       |                     |       |                        |       |
| Property and  equipment                               |       | (81,377                  | )          | (78,010                     | )          |
| Net deferred tax  liabilities                         |       | $                        | (38,420    | )                           | $          | (36,603 | ) |
| Components of  net deferred tax assets (liabilities): |       |                     |       |                        |       |
| Current assets                                        |       | $                        | 427        |                        | $          | 439 |   |
| Non-current  liabilities                              |       | (38,847                  | )          | (37,042                     | )          |
|                                                  |       | $                        | (38,420    | )                           | $          | (36,603 | ) |

 

15

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Forthe three months ended March 31, 2006 and 2005, the Company’s effectiveincome tax rates were different than the statutory federal income tax rates forthe following reasons:

 
| ** **                                             | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| ** **                                             | ** ** | **(In thousands)**                          | ** ** |
| Income tax  expense (benefit) at statutory rate of 35% |       | $                                                | 1,818      |   | $ | (4,720 | ) |
| Tax depletion in  excess of basis                      |       | (158                                             | )          | (112 | ) |
| State income  taxes, net of federal tax effect         |       | 90                                               |       | 337 |   |
| Other                                                  |       | 68                                               |       | — |   |
| Income tax  expense (benefit)                          |       | $                                                | 1,818      |   | $ | (4,495 | ) |
| Current                                                |       | $                                                | —     |   | $ | 156 |   |
| Deferred                                               |       | 1,818                                            |       | (4,651 | ) |
| Income tax  expense (benefit)                          |       | $                                                | 1,818      |   | $ | (4,495 | ) |

 

At March 31,2006, the Company’s cumulative tax loss carryforwards were approximately $18 million.Based upon current commodity prices and production volumes, as well as theavailability of tax planning strategies (such as elective capitalization ofintangible drilling costs), the Company believes that it is more likely thannot that the Company will be able to utilize these tax loss carryforwardsbefore they expire (beginning in 2008).  Accordingly, no valuationallowance has been provided at March 31, 2006.

 

**10.****         ****Investment**

 

InApril 2006, the Company invested $500,000 in a joint venture (“Larclay JV”)with Lariat Services, Inc. (“Lariat”) to own and operate 12 new drilling rigs. TheCompany and Lariat each own a 50% interest in Larclay JV. The rigs are beingconstructed on behalf of Larclay JV by Lariat, as operations manager. Constructionof all the rigs is expected to be completed by February 28, 2007 at a cost ofapproximately $75 million. A lender has provided a $75 million creditfacility to Larclay JV to finance the construction and equipping of the rigs. Pursuantto the terms of the credit facility, the Company has issued a $19 millionletter of credit to the lender as additional collateral during the constructionperiod. Upon the earlier of compliance with specified collateral ratios orFebruary 28, 2007, the lender will release the letter of credit in exchange fora $19.5 million guaranty from the Company. After completion of the constructionperiod, outstanding advances under the credit facility must not exceed 75% ofthe appraised value of the rigs. If proceeds available to Larclay JV under thecredit facility are not sufficient to fully finance the cost of the rigs, theCompany will be required to loan funds to Larclay JV at the same interest rateas the credit facility. The Larclay JV credit facility bears interest at afloating rate based on a LIBOR average, plus 3.25%, and provides for interestpayments through March 2007 and principal and interest payments thereaftersufficient to retire the principal balance by 35% in the first year, 25% ineach of the next two years, and 15% in the fourth year. Two voluntaryprepayments of $10 million each may be made in 2008 and 2009 without aprepayment penalty. The Larclay JV credit facility prohibits Larclay JV frommaking any cash distributions to the Company or Lariat until the balance on thecredit facility is fully repaid, and repayments by Larclay JV of any loans bythe Company or Lariat are subordinated to the loans outstanding under thecredit facility and are subject to other restrictions.

 

Alsoin April 2006, the Company entered into a three-year drilling contract withLarclay JV assuring the availability of each rig for use in the ordinary courseof the Company’s exploration and development drilling program throughout theterm of the drilling contract. The provisions of the drilling contract require

 

16

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that the Company contract for each rig on a well-by-well basis at thencurrent market rates. If a rig is not needed by the Company at any time duringthe term of the contract, Larclay JV may contract with Lariat, affiliates ofLariat or other third party operators for the use of such rig, subject tocertain restrictions. If a rig is idle, the Company will pay Larclay JV an idlerig rate ranging from $8,100 per day to $10,300 per day (plus crew laborexpenses, if applicable), depending on the size of the rig.

 

**11.****         ****Commitments**

 

Inaddition to the rigs the Company has committed to use pursuant to the drillingcontract described in Note 10, the Company is presently obligated under firmorders for two drilling rigs and related equipment in an aggregate amount of$18.1 million. The total cost of the rigs, when completed and fullyequipped, will be approximately $24 million. The rigs are scheduled fordelivery in mid-2007 and are expected to be utilized to drill the Company’sdeep Bossier prospects in East Texas and North Louisiana.

 

**12.****         ****Exploratory Drilling Costs**

 

InApril 2005, the Financial Accounting Standards Board issued Staff Position No. 19-1(“FSP 19-1”). FSP 19-1 amends the present guidance in Statement ofFinancial Accounting Standards No. 19, paragraphs 31 and 34, regardingwhen exploratory drilling costs pending determination of proved reserves can becarried as an asset of an oil and gas company that uses the successful efforts methodof accounting. The Company was required to adopt FSP 19-1, including itsdisclosures, effective July 1, 2005. The adoption of FSP 19-1 did not havea significant impact on the Company’s results of operations. At March 31,2006 and December 31, 2005, the Company had capitalized $15.8 millionand $10.3 million, respectively, of exploratory drilling costs applicableto wells that were pending determination of proved reserves. Of the$10.3 million costs at December 31, 2005, $1.2 million wasexpensed as a dry hole during the three months ended March 31, 2006,$2.1 million was subsequently deemed productive and the remaining $7 millionexploratory drilling costs were still pending determination of proved reserves.

 

17

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**Item 2 -****          Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

The following discussion is intended to provideinformation relevant to an understanding of our financial condition, changes inour financial condition and our results of operations and cash flows and shouldbe read in conjunction with our consolidated financial statements and notesthereto included elsewhere in this Form 10-Q and in our Form 10-K for theyear ended December 31, 2005.

 

**Overview**

 

We are an oil and natural gas exploration,development, acquisition and production company. Our basic business model is tofind and develop oil and gas reserves through exploration and developmentactivities, and sell the production from those reserves at a profit. To besuccessful, we must, over time, be able to find oil and gas reserves and thensell our discovered production at a price that is sufficient to cover ourfinding costs, operating expenses, administrative costs and interest expense,plus offer us a return on our capital investment. From time to time, wemay also acquire producing properties if we believe the acquired assets offerus the potential for reserve growth through additional developmental or exploratorydrilling activities.

 

We believe that the economic climate in thedomestic oil and gas industry continues to be suitable for our business model. Oiland gas prices have remained strong. Supply and demand fundamentals continue tosuggest that energy prices will remain high for the near term, providing uswith the economic incentives necessary for us to assume the risks we face inour search for oil and gas reserves. On the downside, however, we are also experiencing significant costincreases in almost all areas of our business activities, especially indrilling and production costs. High demand for oilfield services is being metwith shortages in equipment and trained personnel, resulting in rate increases.While profit margins still remain favorable, operating metrics per Mcfe, suchas finding costs, production costs and overhead costs, are rising.

 

**KeyFactors to Consider**

 

The following summarizes the key factors consideredby management in the review of our financial condition and operating performancefor the first quarter of 2006 and the outlook for the remainder of 2006.

 

•    We spent$68.1 million on exploration and development activities during the firstquarter of 2006, most of which was on exploratory prospects, and we now plan tospend approximately $222.7 million for the year 2006. These levels ofexpenditures are significantly higher than our anticipated cash flow fromoperations in 2006.

 

•    Weincreased borrowings under our revolving credit facility from$10.7 million to $66.7 million to partially finance our explorationand development activities.

 

•    We recorded a $1.6 million netloss on derivatives during the first quarter of 2006. Cash settlements tocounterparties accounted for $8.1 million of this loss offset by a$6.5 million gain for changes in mark-to-market valuations. Since we donot presently designate our derivatives as cash flow hedges under applicableaccounting standards, we recognize the full effect of changing prices onmark-to-market valuations as a current charge or credit to our results ofoperations.

 

•    Explorationcosts related to abandonments and impairments totaled $12.8 million duringthe first quarter of 2006, most of which was attributable to South Louisianaand Montana.

 

18

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•            Financing arrangements have been completedfor the construction of 12 new drilling rigs to be owned and operated by ajoint venture in which we own a 50% interest.

 

•            We have placed firm orders for two drillingrigs and related equipment in an aggregate amount of $18.1 million.

 

**Recent Exploration and Developmental Activities**

 

***Overview***

 

As shown in “Liquidity and Capital Resources –Capital Expenditures,” we incurred expenditures for exploration and developmentactivities of $68.1 million during the first quarter of 2006. We have alsoincreased our estimates for capital expenditures in fiscal 2006 from$184.1 million to $222.7 million. Approximately 40% of our firstquarter 2006 expenditures were lease purchases and seismic and other explorationcosts.

 

We are actively acquiring leases in North Louisianaand East Texas in order to establish a significant acreage position for futureexploratory and, if successful, developmental drilling activities. We believethat the reserve potential in these areas is significant and warrants thisinvestment in acreage.

 

***South Louisiana***

 

The following table sets forth certain informationabout our exploratory well activities in south Louisiana subsequent toDecember 31, 2005.

 
| **Spud Date** | ** ** | **Well Name (Prospect)** | ** ** | **Working  Interest** | ** ** | **Current  Status**               | ** ** |
|--------------------|------------|------------------------------------|------------|-----------------------|------------|-----------------------------------|------------|
| January 2006       |       | Borah #1  (Cypress Isle)           |       | 75                    | %          | Dry                               |       |
| February 2006      |       | SL 195 QQ #2  (Floyd)              |       | 81.3                  | %          | Waiting on  production facilities |       |
| February 2006      |       | SL 195 QQ #3  (Floyd)              |       | 75                    | %          | Waiting on  production facilities |       |
| March 2006         |       | SL 195 QQ #4  (Floyd)              |       | 75                    | %          | Completing                        |       |
| March 2006         |       | A. J. Beshel  #1 (Beshel)          |       | 100                   | %          | Completing                        |       |
| April 2006         |       | Cobena #1  (Boa II)                |       | 62.5                  | %          | Drilling                          |       |

 

We completed the first three wells on the Floydprospect in Plaquemines Parish as gas wells. We have also drilled and loggedthe State Lease 195 QQ #4. This well encountered multiple pay zones and iscurrently being completed. We presently plan to drill four additional wells onthis acreage. Under the terms of a farmout agreement, we bear 100% of the costson these wells before casing point to earn a 75% working interest in thedrilled acreage.

 

We have also drilled and logged the A.J. Beshel #1,a 12,000-foot exploratory well in Plaquemines Parish. This well alsoencountered potentially productive sands and is currently being completed. Weown 100% of the working interest in this well.

 

We also abandoned the Borah #1 (Cypress Isle), a17,500-foot exploratory well in St. Martin Parish after determining that thewell was nonproductive. We recorded a pre-tax charge of $7.8 millionrelated to the abandonment of this well in the first quarter of 2006, and willrecord an additional pre-tax charge of approximately $2.5 million in the secondquarter of 2006.

 

19

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***North Louisiana***

 

We are currently completing the Harris #1, a14,500-foot exploratory well in Jackson Parish targeting the Bossier formation,in which we own a 53% working interest. While we do not currently expect thereserves from this well to be substantial, we do believe the well will beproductive. We plan to spud our next Bossier well in the third quarter 2006. Inaddition, we have participated in 11 non-operated Cotton Valley/Hosston wellsin which our working interests have ranged from 1% to 44%. Currently, six of thewells are producing, three are completing, and two are drilling. We plan tospud our first operated Cotton Valley/Hosston well in the second quarter of2006.

 

***Other***

 

We have continued to acquire leases in the Bossierplay in East Texas, and to date have acquired approximately 35,000 net acres.We have also abandoned the Ruegsegger 24H #1, a 7,600-foot exploratory well inSheridan County, Montana, and recorded a pre-tax charge of $1.9 millionrelated to the abandonment of this well in the first quarter of 2006.

 

20

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**Supplemental Information**

 

Thefollowing unaudited information is intended to supplement the consolidatedfinancial statements included in this Form 10-Q with data that is not readilyavailable from those statements.

 
| ** **                                                                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| **Oil and Gas Production Data:**                                                         | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Gas (MMcf)                                                                               |       | 3,463                                            |       | 4,761 |   |
| Oil (MBbls)                                                                              |       | 555                                              |       | 619 |   |
| Natural gas liquids (MBbls)                                                              |       | 48                                               |       | 66 |   |
| Total (MMcfe)                                                                            |       | 7,081                                            |       | 8,871 |   |
| **Average Realized Prices (a):**                                                         | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Gas ($/Mcf)                                                                              |       | $                                                | 7.22       |   | $ | 6.22 |   |
| Oil ($/Bbl)                                                                              |       | $                                                | 60.01      |   | $ | 47.83 |   |
| Natural gas liquids ($/Bbl):                                                             |       | $                                                | 38.90      |   | $ | 27.50 |   |
| **Gains (Losses) on Settled Derivative  Contracts (a):**($in thousands, except per unit) | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Gas:    Net  realized gain (loss)                                         |       | $                                                | (2,178     | ) | $ | 708 |   |
| Per unit produced ($/Mcf)                                                                |       | $                                                | (0.63      | ) | $ | 0.15 |   |
| Oil:      Net  realized loss                                    |       | $                                                | (5,895     | ) | $ | (4,220 | ) |
| Per unit produced ($/Bbl)                                                                |       | $                                                | (10.62     | ) | $ | (6.82 | ) |
|                                                                                     |       |                                             |       |   |   |
| **Average Daily Production:**                                                            | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Natural Gas (Mcf):                                                                       |       |                                             |       |   |   |
| Permian Basin                                                                            |       | 13,824                                           |       | 16,156 |   |
| Louisiana                                                                                |       | 9,466                                            |       | 15,272 |   |
| Austin Chalk (Trend)                                                                     |       | 3,261                                            |       | 2,558 |   |
| Cotton Valley Reef Complex                                                               |       | 11,439                                           |       | 18,014 |   |
| Other                                                                                    |       | 488                                              |       | 900 |   |
| Total                                                                                    |       | 38,478                                           |       | 52,900 |   |
| Oil (Bbls):                                                                              |       |                                             |       |   |   |
| Permian Basin                                                                            |       | 3,216                                            |       | 3,332 |   |
| Louisiana                                                                                |       | 1,079                                            |       | 1,474 |   |
| Austin Chalk (Trend)                                                                     |       | 1,828                                            |       | 2,033 |   |
| Other                                                                                    |       | 44                                               |       | 39 |   |
| Total                                                                                    |       | 6,167                                            |       | 6,878 |   |
| Natural Gas Liquids (Bbls):                                                              |       |                                             |       |   |   |
| Permian Basin                                                                            |       | 262                                              |       | 233 |   |
| Austin Chalk (Trend)                                                                     |       | 258                                              |       | 337 |   |
| Other                                                                                    |       | 13                                               |       | 163 |   |
| Total                                                                                    |       | 533                                              |       | 733 |   |

 

21

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| ** **                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                               | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| **Exploration Costs (in thousands):**    |       |                                             |       |   |   |
| Abandonment and impairment costs:        |       |                                             |       |   |   |
| Louisiana                                |       | $                                                | 8,008      |   | $ | 1,272 |   |
| Permian Basin                            |       | 2,202                                            |       | 288 |   |
| Montana                                  |       | 1,933                                            |       | — |   |
| Mississippi                              |       | 679                                              |       | 2,464 |   |
| Cotton Valley Reef Complex               |       | 11                                               |       | 7,246 |   |
| Other                                    |       | 10                                               |       | — |   |
| Total                                    |       | 12,843                                           |       | 11,270 |   |
|                                     |       |                                             |       |   |   |
| Seismic and other                        |       | 3,101                                            |       | 788 |   |
| Total exploration costs                  |       | $                                                | 15,944     |   | $ | 12,058 |   |
| ** **                               |       |                                             |       |   |   |
| **Oil and Gas Costs ($/Mcfe Produced):** |       |                                             |       |   |   |
| Production costs                         |       | $                                                | 2.11       |   | $ | 1.42 |   |
| Oil and gas depletion                    |       | $                                                | 1.97       |   | $ | 1.30 |   |
|                                     |       |                                             |       |   |   |
| **Net Wells Drilled (b):**               |       |                                             |       |   |   |
| Exploratory Wells                        |       | 7.6                                              |       | 3.3 |   |
| Developmental Wells                      |       | 1.7                                              |       | 8.9 |   |

 

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(a)                          No derivatives were designated as cash flowhedges in 2006 or 2005. All gains or losses on settled derivatives wereincluded in loss on derivatives.

(b)                         Excludes wells being drilled or completed atthe end of each period.

 

**Operating Results – Three-Month Periods**

 

The following discussion compares our results forthe three months ended March 31, 2006 to the comparative period in 2005.Unless otherwise indicated, references to 2006 and 2005 within this sectionrefer to the respective quarterly period.

 

***Oil and gas operating results***

 

Oil and gas sales in 2006 decreased 2% from 2005.Oil and gas sales decreased $1.3 million, of which price variancesaccounted for a $10.8 million increase and production variances accountedfor a $12.1 million decrease.

 

Production in 2006 (on an Mcfe basis) was 20% lowerthan 2005. Our oil production decreased 10% in 2006 from 2005 due in part tolost production in Louisiana as a result of hurricane damage and normalproduction declines on existing wells. Our gas production decreased 27% in 2006from 2005 due partially to lost gas production from the hurricanes and byproduction declines in the Cotton Valley Reef Complex area due to formationperformance.

 

In 2006, our realized oil price was 25% higher than2005, while our realized gas price was 16% higher. Historically, the marketsfor oil and gas have been volatile, and they are likely to continue to bevolatile.

 

22

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Oil and gas production costs on an Mcfe basisincreased from $1.42 per Mcfe in 2005 to $2.11 per Mcfe in 2006. The increasein operating costs in 2006 was due primarily to higher oilfield service costsand an increase in workover activities, combined with a production decline of20% on an Mcfe basis for the current period. It is likely that these factorswill continue to contribute to higher production costs in future periods.

 

Depreciation, depletion, and amortization (“DD&A”)expense attributable to our oil and gas properties increased from$12.3 million in 2005 to $14.7 million in 2006. Rate variancesaccounted for a $4.9 million increase in DD&A expense and productionvariances accounted for a $2.5 million decrease. On an Mcfe basis,DD&A expense increased 52% from $1.30 per Mcfe in 2005 to $1.97 per Mcfe in2006. Depletion rates for each depletable group are a function of netcapitalized costs and estimated reserve quantities.

 

General and administrative (“G&A”) expensesincreased from $2.5 million in 2005 to $4.1 million in 2006 dueprimarily to higher personnel costs and professional fees derived from theincrease in overall drilling and exploration activities.

 

***Exploration costs***

 

Since we follow the successful efforts method ofaccounting, our results of operations are adversely affected during anyaccounting period in which significant seismic costs, exploratory dry holecosts, and unproved acreage impairments are expensed.  In 2006, we chargedto expense $15.9 million of exploration costs, as compared to$12.1 million in 2005.  Most of these costs were incurred inLouisiana and Montana as a result of the abandonments of the Borah #1 (CypressIsle) and the Ruegsegger 24H #1.

 

We plan to spend approximately $222.7 millionon exploration and development activities in fiscal 2006, of whichapproximately 90% is expected to be allocated to exploration activities. Since exploratory drilling involves a high degree of risk, it is likely that asignificant portion of the remaining costs in fiscal 2006 will be charged toexploration costs. However, we cannot predict our success rates and,accordingly, cannot predict our exploration costs related to abandonment andimpairment costs.

 

***Interest expense***

 

Interest expense increased from $2.4 million in2005 to $4.3 million in 2006 due primarily to higher average levels ofindebtedness. In July 2005, we repaid all outstanding balances on our bankindebtedness using proceeds from the issuance of $225 million of 73⁄4%Senior Notes due 2013 (the “Senior Notes”) which bear interest at a fixed rateof 7.75%. The weighted average debt outstanding on our bank credit facilitiesat March 31, 2006 was $43.5 million compared to $183.2 millionat March 31, 2005.

 

***Loss on derivatives***

 

We recorded a loss on derivatives of$1.6 million in 2006 compared to a loss of $35.1 million for 2005. Wedid not designate any derivative contracts in 2006 or 2005 as cash flow hedges;therefore all cash settlements and changes resulting from mark-to-marketvaluations have been recorded as losses on derivatives. Cash settlements were$8.1 million in 2006, as compared to $3.6 million in 2005. Werecorded a gain on derivatives of $6.5 million in 2006 compared to a lossof $31.5 million in 2005 resulting from mark-to-market valuations.

 

23

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**Liquidity and Capital Resources**

 

***Overview***

 

Our primary financial resource is our base of oiland gas reserves. We pledge our producing oil and gas properties to a group ofbanks to secure our revolving credit facility. The banks establish a borrowingbase by making an estimate of the collateral value of our oil and gasproperties. We borrow funds on the revolving credit facility as needed tosupplement our operating cash flow as a financing source for our capitalexpenditure program. Our ability to fund our capital expenditure program isdependent upon the level of product prices and the success of our explorationprogram in replacing our existing oil and gas reserves. If product pricesdecrease, our operating cash flow may decrease and the banks may requireadditional collateral or reduce our borrowing base, thus reducing fundsavailable to fund our capital expenditure program. The effects of productprices on cash flow can be mitigated through the use of commodity derivatives.If we are unable to replace our oil and gas reserves through our explorationprogram, we may also suffer a reduction in our operating cash flow and accessto funds under the revolving credit facility. Under extreme circumstances,product price reductions or exploration drilling failures could allow the banksto seek to foreclose on our oil and gas properties, thereby threatening ourfinancial viability.

 

In July 2005, we reduced our dependence on theborrowing base established for the revolving credit facility by issuing$225 million of aggregate principal amount of Senior Notes and using thenet proceeds to repay all amounts outstanding on the revolving credit facilityand the senior term credit facility. However, we have recently drawn advancesunder the revolving credit facility to partially finance our exploration anddevelopment activities. At March 31, 2006, we had $66.7 millionoutstanding on the revolving credit facility.

 

In this section, we will describe our current plansfor capital spending, identify the capital resources available to finance ourcapital spending, and discuss the principal factors that can affect ourliquidity and capital resources.

 

***Capital expenditures***

 

Our planned expenditures for exploration anddevelopment activities during 2006 total $222.7 million, as summarized byarea in the following table.

 
| ** **           | ** ** | **Actual**                   | ** ** | **Total**                       | ** ** | ** **        | ** ** |
|----------------------|------------|------------------------------|------------|---------------------------------|------------|-------------------|------------|
| ** **           | ** ** | **Expenditures**             | ** ** | **Planned**                     | ** ** | ** **        | ** ** |
| ** **           | ** ** | **Three Months**        | ** ** | **Expenditures**                | ** ** | ** **        | ** ** |
| ** **           | ** ** | **Ended**                    | ** ** | **Year Ended**             | ** ** | **Percentage**    | ** ** |
| ** **           | ** ** | **March 31, 2006** | ** ** | **December 31, 2006** | ** ** | **of Total** | ** ** |
| ** **           | ** ** | **(In thousands)**      | ** ** | ** **                      | ** ** |
| North Louisiana      |       | $                            | 12,600     |                            | $          | 85,800            |       | 40 | % |
| South Louisiana      |       | 26,200                       |       | 76,600                          |       | 34                | %          |
| East Texas (Bossier) |       | 11,200                       |       | 27,200                          |       | 12                | %          |
| Permian Basin        |       | 12,300                       |       | 18,100                          |       | 8                 | %          |
| Utah/Montana         |       | 3,800                        |       | 7,600                           |       | 3                 | %          |
| Austin Chalk (Trend) |       | 1,100                        |       | 2,900                           |       | 1                 | %          |
| Other                |       | 900                          |       | 4,500                           |       | 2                 | %          |
|                 |       | $                            | 68,100     |                            | $          | 222,700           |       | 100 | % |

 

24

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Our actual expenditures during fiscal 2006 may besubstantially higher or lower than these estimates since our plans forexploration and development activities may change during the year. Otherfactors, such as prevailing product prices and the availability of capitalresources, could also increase or decrease the ultimate level of expendituresduring fiscal 2006.

 

Approximately 90% of the planned expenditures relateto exploratory prospects. Exploratory prospects involve a higher degree of riskthan developmental prospects. To offset the higher risk, we generally strive toachieve a higher reserve potential and rate of return on investments inexploratory prospects. We do not attempt to forecast our success rate onexploratory drilling. Accordingly, these current estimates do not include costswe may incur to complete any future successful exploratory wells and constructthe required production facilities for these wells. Also, we are activelysearching for other opportunities to increase our oil and gas reserves,including the evaluation of new prospects for exploratory and developmentaldrilling activities and potential acquisitions of proved oil and gasproperties.

 

At our current level of planned activity for 2006,we project that more than half of the cash needed to finance our plannedexpenditures for exploration and development activities in fiscal 2006 will beprovided by operating activities. To the extent that actual costs exceed ourcash provided by operating activities, we plan to utilize the revolving creditfacility to finance such excess. We borrowed $56 million under ourrevolving credit facility during the first quarter of 2006 and expect to borrowadditional amounts during the remainder of fiscal 2006.

 

*Drilling Rig Joint Venture*

In April 2006, we invested $500,000 in a jointventure (“Larclay JV”) with Lariat Services, Inc. (“Lariat”) to own and operate12 new drilling rigs. CWEI and Lariat each own a 50% interest in Larclay JV.The rigs are being constructed on behalf of Larclay JV by Lariat, as operationsmanager. Construction of all the rigs is expected to be completed by February28, 2007 at a cost of approximately $75 million. A lender has provided a$75 million credit facility to Larclay JV to finance the construction andequipping of the rigs. Pursuant to the terms of the credit facility, we have issueda $19 million letter of credit to the lender as additional collateralduring the construction period. Upon the earlier of compliance with specifiedcollateral ratios or February 28, 2007, the lender will release the letter ofcredit in exchange for a $19.5 million guaranty from us. After completionof the construction period, outstanding advances under the credit facility mustnot exceed 75% of the appraised value of the rigs. If proceeds available toLarclay JV under the credit facility are not sufficient to fully finance thecost of the rigs, we will be required to loan funds to Larclay JV at the sameinterest rate as the credit facility. The Larclay JV credit facility bearsinterest at a floating rate based on a LIBOR average, plus 3.25%, and providesfor interest payments through March 2007 and principal and interest paymentsthereafter sufficient to retire the principal balance by 35% in the first year,25% in each of the next two years, and 15% in the fourth year. Two voluntaryprepayments of $10 million each may be made in 2008 and 2009 without aprepayment penalty. The Larclay JV credit facility prohibits Larclay JV frommaking any cash distributions to us or to Lariat until the balance on thecredit facility is fully repaid, and repayments by Larclay JV of any loans byus or by Lariat are subordinated to the loans outstanding under the creditfacility and are subject to other restrictions.

 

At March 31, 2006, we had advanced Larclay JV$16.8 million for interim construction costs. In April 2006, Larclayrepaid the full amount of the advances from the proceeds of its creditfacility.

 

Also in April 2006, we entered into a three-yeardrilling contract with Larclay JV assuring the availability of each rig for usein the ordinary course of our exploration and development drilling programthroughout the term of the drilling contract. The provisions of the drillingcontract require that we contract for each rig on a well-by-well basis at thencurrent market rates. If a rig is not needed by us at any time

 

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during the term of the contract, Larclay JVmay contract with Lariat, affiliates of Lariat or other third party operatorsfor the use of such rig, subject to certain restrictions. If a rig is idle, wewill pay Larclay JV an idle rig rate ranging from $8,100 per day to $10,300 perday (plus crew labor expenses, if applicable), depending on the size of therig.

 

Our gross idle rig commitment under the drillingcontract with Larclay JV aggregates approximately $114 million over thethree-year term of the contract. We plan to mitigate our exposure to our idlerig commitment by permitting Larclay JV to contract with other operators duringany time which we do not need specified rigs in our drilling program. As weutilize the Larclay JV rigs in the ordinary course of our drilling program, thecost of such rigs will be included in our exploration and developmentexpenditures.

 

In addition to the rigs we have committed to usepursuant to the drilling contract with Larclay JV described above, we aredirectly committed under firm orders for two drilling rigs and relatedequipment in an aggregate amount of $18.1 million. The total cost of therigs, when completed and fully equipped, will be approximately $24 million.The rigs are scheduled for delivery in mid-2007 and are expected to be utilizedto drill our deep Bossier prospects in East Texas and North Louisiana.

 

***Cash flow provided by operatingactivities***

 

Substantially all of our cash flow from operatingactivities is derived from the production of our oil and gas reserves. We usethis cash flow to fund our on-going exploration and development activities insearch of new oil and gas reserves. Variations in cash flow from operatingactivities may impact our level of exploration and development expenditures.

 

Cash flow provided by operating activities for thethree months ended March 31, 2006 was 25% higher than the same period in2005 due to the combined effects of several factors. Oil and gas sales, net ofproduction costs, general and administrative costs and interest expense, were$7.2 million lower in the first quarter 2006 as compared to the sameperiod in 2005. However, changes in working capital resulted in an increase inthe current quarter of $11.2 million as compared to a decrease in the 2005quarter of $2.7 million. Our primary source of cash from operatingactivities is our oil and gas sales, net of production costs. Our cash flowprovided by operating activities is subject to material variation from changes inoil and gas production levels and product prices. Higher oil and gas pricesalso resulted in an increase in cash required to settle derivative contracts,excluding those contracts that contain a financing element as in the case ofthe contracts assumed in our acquisition of Southwest Royalties, Inc. in May2004. Interest expense increased in 2006 due primarily to higher levels ofindebtedness resulting from the issuance of the Senior Notes.

 

***Credit facilities***

 

A group of banks have provided us with a revolvingcredit facility on which we have historically relied for both our short-termliquidity (working capital) and our long-term financing needs. The fundsavailable to us at any time under this revolving credit facility are limited tothe amount of the borrowing base established by the banks. As long as we havesufficient availability under this credit facility to meet our obligations asthey come due, we will have sufficient liquidity and will be able to fund anyshort-term working capital deficit.

 

At the beginning of 2006, we had an outstandingbalance under the revolving credit facility of $10.7 million, and theborrowing base was $150 million, providing us with available funds of$138.5 million after accounting for outstanding letters of credit. Duringthe three months ended March 31,

 

26

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2006,we generated cash flow from operating activities of $37.5 million. We alsospent $83.1 million on capital expenditures and other investments and paid$7.9 million to settle derivatives with financing elements. To finance theexcess of exploration over cash flow, we borrowed $56 million on therevolving credit facility, reducing our availability at March 31, 2006 to$82.5 million.

 

Using the revolving credit facility for both ourshort-term liquidity and long-term financing needs can cause unusualfluctuations in our reported working capital, depending on the timing of cashreceipts and expenditures. On a daily basis, we use most of our available cashto pay down our outstanding balance on the revolving credit facility, which isclassified as a non-current liability since we currently have no requiredprincipal reductions. As we use cash to pay a non-current liability, ourreported working capital decreases. Conversely, as we draw on the revolvingcredit facility for funds to pay current liabilities (such as payables fordrilling and operating costs), our reported working capital increases. Also,volatility in oil and gas prices can cause significant fluctuations in reportedworking capital as we record changes in the fair value of derivatives fromperiod to period. For these reasons, the working capital covenant related tothe revolving credit facility requires us to (i) include the amount offunds available under this facility as a current asset, (ii) excludecurrent assets and liabilities related to the fair value of derivatives, and(iii) exclude current maturities of vendor finance obligations, if any, whencomputing the working capital ratio at any balance sheet date.

 

Working capital computed for loan compliancepurposes differs from our working capital in accordance with generally acceptedaccounting principles (GAAP). Since compliance with financial covenants is amaterial requirement under the credit facilities, we consider the loancompliance working capital to be useful as a measure of our liquidity becauseit includes the funds available to us under the revolving credit facility andis not affected by the volatility in working capital caused by changes in fairvalue of derivatives. Our reported working capital deficit decreased from$35.8 million at December 31, 2005 to $24.6 million atMarch 31, 2006 due primarily to a combination of factors, includingdecreases in accounts payable and increases in inventory. After giving effectto the adjustments, our working capital computed for loan compliance purposeswas a positive $89.4 million at March 31, 2006, as compared to apositive $136.2 million at December 31, 2005. The following tablereconciles our GAAP working capital to the working capital computed for loancompliance purposes at March 31, 2006 and December 31, 2005.

 
| ** **                                                                             | ** ** | **March 31,  2006**     | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                             | ** ** | **(In thousands)** | ** ** |
| Working  capital (deficit) per GAAP                                                    |       | $                       | (24,605    | )                      | $          | (35,812 | ) |
| Add funds  available under the revolving credit facility                               |       | 82,496                  | (a)        | 138,496                |       |
| Exclude fair  value of derivatives classified as current assets or current liabilities |       | 31,518                  |       | 33,479                 |       |
| Working  capital per loan covenant                                                     |       | $                       | 89,409     |                   | $          | 136,163 |   |
|                                                                                        |            |                         |            |                        |            |  |  |  |

 

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(a)          Subsequent to March 31, 2006, we issued a letter of credit in theamount of $19 million in connection with the financing of drilling rigsowned by Larclay JV.

 

Since we usethis revolving credit facility for both short-term liquidity and long-termfinancing needs, it is important that we comply in all material respects withthe loan agreement, including financial covenants that are computed quarterly.The working capital covenant requires us to maintain positive working capitalusing the computations described above. Another financial covenant under thecredit facility requires us to maintain a ratio of indebtedness to cash flow ofno more than 3 to 1. While we were in compliance with all financial andnon-financial covenants at March 31, 2006, our increased leverage andreduced liquidity may

 

27

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result in our failing to comply with one ormore of these covenants in the future.  If we fail to meet any of theseloan covenants, we would ask the banks to allow us sufficient time to obtain additionalcapital resources through alternative means. If a suitable arrangement couldnot be reached with the banks, the banks could accelerate the indebtedness andseek to foreclose on the pledged assets. However, the issuance of the SeniorNotes described below significantly increases our liquidity and reduces ourdependence on the revolving credit facility.

 

The banks redetermine theborrowing base under the revolving credit facility at least twice a year, inMay and November. If at any time, the borrowing base is less than the amount ofoutstanding indebtedness, we will be required to (i) pledge additionalcollateral, (ii) prepay the excess in not more than five equal monthlyinstallments, or (iii) elect to convert the entire amount of outstandingindebtedness to a term obligation based on amortization formulas set forth inthe loan agreement. In connection with the issuance of the Senior Notes, theborrowing base was reduced to $132.5 million in July 2005, and alloutstanding balances on our revolving credit facility were repaid. However, wehave recently drawn advances under the revolving credit facility to partiallyfinance our explanation and development activities. At March 31, 2006, wehad $66.7 million outstanding on the revolving credit facility.

 

***73⁄4% Senior Notes due 2013***

 

In July 2005, we issued, ina private placement, $225 million of aggregate principal amount of SeniorNotes. The Senior Notes were issued at face value and will bear interest at 73⁄4%per year, payable semi-annually on February 1 and August 1 of each year,beginning February 1, 2006. After the payment of typical transaction expenses,net proceeds of approximately $217 million were used to repay amountsoutstanding on our secured credit facilities and for general corporate purposes,including the funding of planned exploration and development activities.

 

At any time prior to August1, 2008, we may redeem up to 35% of the aggregate principal amount of theSenior Notes with the proceeds of certain equity offerings at a redemption priceof 107.75% of the principal amount, plus accrued and unpaid interest. Inaddition, prior to August 1, 2009, we may redeem some or all of the SeniorNotes at a redemption price equal to 100% of the principal amount of the SeniorNotes to be redeemed, plus a make-whole premium, plus any accrued and unpaidinterest. On and after August 1, 2009, we may redeem some or all of the SeniorNotes at redemption prices (expressed as percentages of principal amount) equalto 103.875% for the twelve-month period beginning on August 1, 2009,101.938% for the twelve-month period beginning on August 1, 2010, and 100.00%beginning on August 1, 2011, for any period thereafter, in each case plusaccrued and unpaid interest.

 

The Indenture governing theSenior Notes restricts our ability and the ability of our restrictedsubsidiaries to: (i) borrow money; (ii) issue redeemable andpreferred stock; (iii) pay distributions or dividends; (iv) makeinvestments; (v) create liens without securing the Notes; (vi) enterinto agreements that restrict dividends from subsidiaries; (vii) sellcertain assets or merge with or into other companies; (viii) enter intotransactions with affiliates; (ix) guarantee indebtedness; and(x) enter into new lines of business. These covenants are subject to anumber of important exceptions and qualifications. We were in compliance withthese covenants at March 31, 2006.

 

***Alternative capital resources***

 

Although our base of oil andgas reserves, as collateral for both of our credit facilities, has historicallybeen our primary capital resource, we have in the past, and we believe we couldin the future, use alternative capital resources, such as asset sales, vendorfinancing arrangements, and/or public or private issuances of common stock. Wecould also issue senior or subordinated debt or preferred stock in a public ora private 

 

28

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placement if we choose to raise capitalthrough either of these markets. While we believe we would be able to obtainfunds through one or more of these alternatives, if needed, there can be noassurance that these capital resources would be available on terms acceptableto us.

 

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## **Item 3** -                  Quantitative and QualitativeDisclosure About Market Risks

## ** **

Our business is impacted byfluctuations in commodity prices and interest rates. The following discussionis intended to identify the nature of these market risks, describe our strategyfor managing such risks, and to quantify the potential affect of marketvolatility on our financial condition and results of operations.

 

**Oil and Gas Prices**

 

Our financial condition,results of operations, and capital resources are highly dependent upon theprevailing market prices of, and demand for, oil and natural gas. Thesecommodity prices are subject to wide fluctuations and market uncertainties dueto a variety of factors that are beyond our control. These factors include thelevel of global demand for petroleum products, foreign supply of oil and gas, theestablishment of and compliance with production quotas by oil-exportingcountries, weather conditions, the price and availability of alternative fuels,and overall economic conditions, both foreign and domestic. We cannot predictfuture oil and gas prices with any degree of certainty. Sustained weakness inoil and gas prices may adversely affect our financial condition and results ofoperations, and may also reduce the amount of net oil and gas reserves that wecan produce economically. Any reduction in reserves, including reductions dueto price fluctuations, can reduce the borrowing base under our revolving creditfacility and adversely affect our liquidity and our ability to obtain capitalfor our exploration and development activities. Similarly, any improvements inoil and gas prices can have a favorable impact on our financial condition,results of operations and capital resources. Based on December 31, 2005reserve estimates, we project that a $1.00 drop in the price per Bbl of oil anda $.50 drop in the price per Mcf of gas would reduce our gross revenues for theyear ending December 31, 2006 by $11 million.

 

From time to time, weutilize commodity derivatives, consisting primarily of swaps, floors andcollars to attempt to optimize the price received for our oil and natural gasproduction. When using swaps to hedge our oil and natural gas production, wereceive a fixed price for the respective commodity and pay a floating marketprice as defined in each contract (generally NYMEX futures prices), resultingin a net amount due to or from the counterparty. In floor transactions, wereceive a fixed price (put strike price) if the market price falls below theput strike price for the respective commodity. If the market price is greaterthan the put strike price, no payments are due from either party. Costlesscollars are a combination of puts and calls, and contain a fixed floor price(put strike price) and ceiling price (call strike price). If the market pricefor the respective commodity exceeds the call strike price or falls below theput strike price, then we receive the fixed price and pay the market price. Ifthe market price is between the call and the put strike prices, no payments aredue from either party. The commodity derivatives we use differ from futurescontracts in that there is not a contractual obligation that requires orpermits the future physical delivery of the hedged products. We do not enterinto commodity derivatives for trading purposes. In addition to commodityderivatives, we may, from time to time, sell a portion of our gas productionunder short-term contracts at fixed prices.

 

The decision to initiate orterminate commodity hedges is made by management based on its expectation offuture market price movements. We have no set goals for the percentage of ourproduction we hedge and we do not use any formulas or triggers in deciding whento initiate or terminate a hedge. If we enter into swaps or collars and thefloating market price at the settlement date is higher than the fixed price orthe fixed ceiling price, we will forego revenue we would have otherwisereceived. If we terminate a swap, collar or floor because we anticipate futureincreases in market prices, we may be exposed to downside risk that would nothave existed otherwise.

 

30

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The following summarizesinformation concerning our net positions in open commodity derivativesapplicable to periods subsequent to March 31, 2006. The settlement pricesof commodity derivatives are based on NYMEX futures prices.

 

**Collars:**

** **
| ** **          | ** ** | **Gas**       | ** ** | **Oil**   | ** ** |
|---------------------|------------|---------------|------------|-----------|------------|
| ** **          | ** ** | **MMBtu (a)** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** | **Bbls** | ** ** | **Floor** | ** ** | **Ceiling** | ** ** |
| Production  Period: |       |          |       |      |       |   |   |   |   |   |   |   |   |
| 2nd Quarter 2006    |       | 551,000       |       | $         | 4.00       |   | $ | 5.21 |   | 156,000 |   | $ | 23.00 |   | $ | 25.32 |   |
| 3rd Quarter 2006    |       | 456,000       |       | $         | 4.00       |   | $ | 5.21 |   | 150,000 |   | $ | 23.00 |   | $ | 25.32 |   |
| 4th Quarter 2006    |       | 456,000       |       | $         | 4.00       |   | $ | 5.21 |   | 150,000 |   | $ | 23.00 |   | $ | 25.32 |   |
| 2007                |       | 1,831,000     |       | $         | 4.00       |   | $ | 5.18 |   | 562,000 |   | $ | 23.00 |   | $ | 25.20 |   |
| 2008                |       | 1,279,000     |       | $         | 4.00       |   | $ | 5.15 |   | 392,000 |   | $ | 23.00 |   | $ | 25.07 |   |
|                |       | 4,573,000     |       |      |       |   |   | 1,410,000 |   |   |   |   |   |

 

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(a)           One MMBtu equals one Mcf at a Btu factor of1,000.

 

Subsequent to March 31,2006, we entered into swap agreements covering 1,050,000 MMBtu of gasproduction during the fourth quarter of 2006 at $10.03 per MMBtu and 5,350,000MMBtu of gas production during 2007 at $10.23 per MMBtu.

 

We use a sensitivityanalysis technique to evaluate the hypothetical effect that changes in themarket value of oil and gas may have on the fair value of our commodityderivatives. A $1 per barrel change in the price of oil and a $.50 perMMBtu change in the price of gas would change the fair value of our commodityderivatives by approximately $3 million.

 

**Interest Rates**

 

We are party to interestrate swaps that were acquired in connection with the SWR acquisition. Underthese derivatives, we pay a fixed rate for the notional principal balances andreceives a floating market rate based on LIBOR. The following summarizesinformation concerning our net positions in open interest rate swaps applicableto periods subsequent to March 31, 2006.

 
| ** **                           | ** ** | **Principal   Balance** | ** ** | **Libor   Rates** | ** ** |
|--------------------------------------|------------|------------------------------|------------|------------------------|------------|
| Period:                              |       |                         |       |                   |       |
| April 2006 to November 1, 2006       |       | $                            | 55,000,000 |                   | 4.29       | % |
| November 1, 2006 to November 1, 2007 |       | $                            | 50,000,000 |                   | 5.19       | % |
| November 1, 2007 to November 1, 2008 |       | $                            | 45,000,000 |                   | 5.73       | % |
|                                      |            |                              |            |                        |            |  |  |

 

The interest rate swaps in the preceding tableexpose us to market risks for decreases in interest rates during the periodsshown.

 

31

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**Item 4 -****                                                       Controlsand Procedures**

 

**DisclosureControls and Procedures**

#### ** **

Our Board of Directors hasadopted a policy designed to establish disclosure controls and procedures thatare adequate to provide reasonable assurance that we will be able to collect,process and disclose both financial and non-financial information, on a timelybasis, in our reports to the SEC and other communications with ourstockholders. Disclosure controls and procedures include all processesnecessary to ensure that material information is recorded, processed,summarized and reported within the time periods specified in the SEC’s rulesand forms, and is accumulated and communicated to our management, including ourchief executive and chief financial officers, to allow timely decisionsregarding required disclosures.

 

With respect to ourdisclosure controls and procedures:

 

•                  We have evaluated the effectiveness of ourdisclosure controls and procedures as of the end of the period covered by thisreport;

 

•                  This evaluation was conducted under thesupervision and with the participation of our management, including our chiefexecutive and chief financial officers; and

 

•                  It is the conclusion of our chief executiveand chief financial officers that these disclosure controls and proceduresoperate such that material information flows to the appropriate collection anddisclosure points in a timely manner and are effective in ensuring thatmaterial information is accumulated and communicated to our management and ismade known to the chief executive and chief financial officers, particularlyduring the period in which this report was prepared, as appropriate to allowtimely decisions regarding required disclosures.

 

#### **Changesin Internal Control Over Financial Reporting**

#### ** **

No changes in internalcontrol over financial reporting were made during the quarter endedMarch 31, 2006 that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

 

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# **PARTII. FINANCIAL INFORMATION**

# ** **

## **Item 1A** -               Risk Factors

 

In evaluating allforward-looking statements, you should specifically consider various factorsthat may cause actual results to vary from those contained in theforward-looking statements. Our risk factors are included in our Annual Report onForm 10-K for the year ended December 31, 2005, as filed with theU.S. Securities and Exchange Commission on March 16, 2006 and available atwww.sec.gov. There have been no material changes to these risk factors sincethe filing of our Form 10-K.

 

**Item 6 -****                                                       Exhibits**

 

#### **Exhibits**

#### ** **

| 3.1**  |   | Second Restated Certificate of Incorporation of  the Company, filed as Exhibit 3.1 to our Form S-2 Registration Statement,  Commission File No. 333-13441                                                                                                                                                                                        |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 3.2**  |   | Certificate of Amendment of Second Restated  Certificate of Incorporation of Clayton Williams Energy, Inc., filed as  Exhibit 3.1 to our Form 10-Q for the period ended September 30, 2000                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 3.3**  |   | Bylaws of the Company, filed as Exhibit 3.4 to our  Form S-1 Registration Statement, Commission File No. 33-43350                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 3.4**  |   | Corporate Bylaws of Clayton Williams Energy, Inc.,  as amended, filed as Exhibit 3.1 to our Current Report on Form 8-K filed  with the Commission on June 1, 2005††                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 4.1**  |   | Indenture, dated July 20, 2005, among Clayton  Williams Energy, Inc., the Subsidiary Guarantors and Wells Fargo Bank,  National Association, as Trustee, filed as Exhibit 4.1 to our Current  Report on Form 8-K filed with the Commission on July 22, 2005††                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 4.2**  |   | Registration Rights Agreement dated July 20, 2005,  among Clayton Williams Energy, Inc., the Subsidiary Guarantors and J.P.  Morgan Securities Inc., filed as Exhibit 4.2 to our Current Report on  Form 8-K filed with the Commission on July 22, 2005††                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.1** |   | First Amendment to Amended and Restated Credit  Agreement dated July 18, 2005, filed as Exhibit 10.1 to our Current  Report on Form 8-K filed with the Commission on July 20, 2005††                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                             |
| 10.2** |   | Limited Liability Company Agreement, dated April  21, 2006, by and between Clayton Williams Energy, Inc. and Lariat Services,  Inc., with respect to the formation of Larclay GP, LLC, a Texas limited  liability company, filed as Exhibit 10.1 to our Current Report on  Form 8-K filed with the Commission on April 26, 2006†† |

 

33

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| 10.3** |   | Agreement of Limited Partnership, dated April 21,  2006, by and among Larclay GP, LLC, Clayton Williams Energy, Inc. and  Lariat Services, Inc., with respect to the formation of Larclay L.P., a Texas  limited partnership, filed as Exhibit 10.2 to our Current Report on  Form 8-K filed with the Commission on April 26, 2006†† |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.4** |   | Drilling Contract for Multiple Rigs, dated April  21, 2006, by and between Clayton Williams Energy, Inc. and Larclay L.P.,  filed as Exhibit 10.3 to our Current Report on Form 8-K filed with the  Commission on April 26, 2006††                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.5** |   | Subordination Agreement, dated April 21, 2006, by  and among Clayton Williams Energy, Inc., Lariat Services, Inc. and Merrill  Lynch Capital, as agent, filed as Exhibit 10.4 to our Current Report on  Form 8-K filed with the Commission on April 26, 2006††                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.6** |   | Consent and Agreement, dated April 21, 2006, by  and among Clayton Williams Energy, Inc., Lariat Services, Inc. and Merrill  Lynch Capital, as agent, filed as Exhibit 10.5 to our Current Report on  Form 8-K filed with the Commission on April 26, 2006††                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.7** |   | Letter of Credit, dated April 21, 2006, issued in  favor of Merrill Lynch Capital, as agent, filed as Exhibit 10.6 to our  Current Report on Form 8-K filed with the Commission on April 26, 2006††                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                     |
| 10.8** |   | Form of Unconditional Limited Guaranty, to be  issued by Clayton Williams Energy, Inc. in favor of Merrill Lynch Capital, as  agent, filed as Exhibit 10.7 to our Current Report on Form 8-K filed  with the Commission on April 26, 2006††                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                     |
| 31.1*  |   | Certification by the President and Chief Executive  Officer of the Company pursuant to Rule 13(a) - 14(a) of the  Securities Exchange Act of 1934                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                     |
| 31.2*  |   | Certification by the Chief Financial Officer of  the Company pursuant to Rule 13(a) - 14(a) of the Securities  Exchange Act of 1934                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                     |
| 32.1*  |   | Certifications by the Chief Executive Officer and  Chief Financial Officer of the Company pursuant to  18 U.S.C. § 1350                                                                                                                                                                                                              |

 

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*      Filed herewith

**     Incorporated by reference to the filingindicated

††      Filed under our Commission FileNo. 001-10924

 

34

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**CLAYTONWILLIAMS ENERGY, INC.**

**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned theretoduly authorized.

 

 
| * * | * *    | **CLAYTON WILLIAMS ENERGY, INC.** |
|----------|-------------|-----------------------------------|
| * * | ** **  |
| * * | ** **  |
| Date:    | May 9, 2006 | By:                               | */s/ L. Paul Latham* |
|     |        |                              | L. Paul Latham |
|     |        |                              | Executive Vice President  and Chief   Operating Officer |
|     |        |                              |   |
|     |        |                              |   |
| Date:    | May 9, 2006 | By:                               | */s/ Mel G. Riggs* |
|     |        |                              | Mel G. Riggs |
|     |        |                              | Senior Vice President and  Chief Financial   Officer |

 

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